Discounting With The Discount Rate
the discount rate is the interest rate you need to earn on a given amount of money today to end up with the given amount of money in the future. let's say you need $1,000 one year from now to go on vacation. we can use the discount rate to determine how much money you would need to have today to have $1,000 in one year. if savings accounts are paying 5% interest, it makes sense to use 5% as the discount rate. in a simple example with savings accounts pay interest all at once at the end of the year, what amount you have to put up now that will equal $1,000 when 5% is added. dividing the future amount of $1,000 by one plus the discount rate will give us the answer, $952.38. this means that if you take $952.38 today and put it into a savings account that pays 5% interest per year, you will have $1,000 in one year and be able to go on vacation. it's important to choose a realistic number for the discount rate, but often you can only make an educated guess. savings accounts might be paying 5% today, but halfway through the year, they might end up paying only 4.5%. if this happens, you won't have the $1,000 you need for your vacation. the discount rate accounts for the time value of money, which is the idea that a dollar today is worth more than a dollar tomorrow, given that the dollar today has the capacity to earn interest. the inverse of the discount rate is the compound interest rate, which estimates how much money you would have in the future based on what you have today.
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